Q&A: DONALE YACKTMAN "THE GREED SIDE HAS OVERTAKEN THE FEAR SIDE"

Think lackluster returns and Donald Yacktman isn’t the first portfolio manager likely to come to mind. Still, that’s the only way to describe the results of Mr. Yacktman’s strict value approach over the last 18 months.

The 6-year-old Yacktman Fund’s 5.5% return through May 31 is 7.6 percentage points off the Standard & Poor’s 500 index’s pace. And last year, its 18.3% return trailed the S&P by more than 15 points.

But the Chicago-based manager, who recently launched a focused fund, has been around the investment business too long to change his discipline now. Maybe that’s why his fans, including crosstown mutual fund evaluator Morningstar Inc., hav e urged patience with him.

Mr. Yacktman, 56, has been through more than a few market cycles, making his name running the Selected American Shares Fund, a perennial top performer, from 1983 until he opened his own firm in 1992. For the 15 years before that, he ran m oney at Chicago-based Stein Roe & Farnham, when it primarily was an investment counselor to the wealthy.

His strategy is to buy stocks at prices well below what he determines to be their private-market value and hold them until the market gradually recognizes their true value. The approach, which he says works best when markets are flat or down, has taken its lumps recently. But Mr. Yacktman figures much of that is due to bull market mania. “The greed side,” he says, “has overtaken the fear side.”

Q With the underperformance, are you rejiggering your approach at all?

A No, no. The only thing is size. We have a preference of big over smaller or middle-sized companies. But the opportunities are in the more profitable, littler companies — or mid-cap companies, I guess I’d say — rather than the behemoth s.

We’ve had a tremendous rise in the market; we have not had a tough period. I’m expecting somewhere down the road there’ll be a tougher period, and we’ll probably look like we’re rocket scientists in that period of time. But I have my own money in there, so I’m as frustrated as anyone else in the short term.

Q How do you find buying opportunities?

A There are three times that we have found you get bargain opportunities in buying stocks. One is a market decline. You get a hit like you did last fall where the market goes down. When that happens, they usually shake the apple tree, so to speak, and something drops out. Now, last fall, the one we picked to home in on was a company called First Data Corp., and First Data had been in the 40s and went to the 20s.

The second alternative is where you have this threat to the cash flows (i.e., from the potential impact of tobacco litigation on Philip Morris), but business is humming.

The third one, which is I think the most common way to find opportunities, is where companies have a short-term problem. It’s sort of like you have a house that, let’s say, is a bargain price, but it just looks ugly at the moment, but it’ s structurally very sound. So, if you take the analogy, if you walk in the kitchen, there’s an ugly crack in the wall, the rooms are painted pea green, if you step on the floor the joists squeak. But most of these are relatively minor corrections that need to be made; these are not major kind of things. The basic underlyi ng business still has great economics to it, or the core of the business has great economics and the management’s messed it up by adding things through acquisitions or otherwise that kind of came in there and took their eye off the ball.

Q What is the point at which you decide to sell a company? Fellow Chicago value manager Harris Associates, which runs the Oakmark Funds, for instance, does have a sell criterion: 90% of what they consider to be the intrinsic value of the c ompany, no questions, even when sometimes they think it might be better to stick around.

A We tend to be a little more gradual. I’m not against the concept at all — I think the concept makes sense — but the problem is the (momentum investors) will tend to drive things beyond your expectations. So I think you’re better off to do things gradually than abruptly. Where you want to do things abruptly are businesses you have less confidence in.

Q And that means less confidence in the managers?

A Ultimately, it becomes the business itself. I think it’s much more difficult to determine what managers do all the time. Even guys who’ve had great track records occasionally go off the reservation.

Q Like who?

A Like at United Asset Management Corp. of Boston — I’d like to see some improvement in that area. But the business is so flippin’ profitable, and it’s selling at such a low price, that you really have got to be terrible to not have this stock work out for you.

UAM is an incredible money machine. But they have diluted themselves because they have been buying other businesses and paying too high a price. You know: The kingdom gets bigger, but the residents are poor, or aren’t building their wealth . We’d rather see them back off if it’s too high or too expensive. But you’ve got to make an evaluation there as to what makes the most sense.

Now, I’ve had ownership personally in that company since 1990. Have I been thrilled? No. There are things they need to do better than what they do. And I’ve tried to talk to them on numerous occasions about changes we’d like to see.

In fact, I told (CEO) Norton Reamer I’d be happy if he canned the dividend and used it to buy back shares. And I think they’re moving in those directions.

Q This brings up an interesting question. Some money managers are more activist than others. Where do you come down on that? Obviously, you try to influence managers one way or another, but it sounds like you try more to cajole them than t o bludgeon them.

A I think that’s always a better way. Occasionally, we’ve had to draw a hard line, but we don’t do it very often. We would rather avoid that.

I know at Franklin Covey Co. (a Salt Lake City-based date-planner company), when they wanted to buy Covey Leadership Center Inc., they really wanted to do a pooling of assets. Their reason was that they would not have to take the goodwill and run it through the income statement, that the stock market really looks at reported earnings per share.

Our argument is that the right number to focus in on is not that number at all, but some number that we’re looking at, or at a minimum, you ought to look at cash earnings per share, which forgets amortization and goodwill.

The other problem in the case of Covey was that if they had gone that route, they would have had to resell a couple million shares they had just bought in the open market.

We said, “That doesn’t make any sense. You have these shares cheap. Why would you want to resell so then you issue more shares?”

By doing what they did, because they didn’t have to sell shares and they were able to go with Covey on a purchase acquisition, we said, “Maybe Covey would rather have some cash than all shares anyway.”

So we figured we reduced the share count probably by 4 million shares by Covey taking some cash and not having to resell their shares in the open market.

We talked to some of the other major holders, and in effect we all kind of — I wouldn’t say we ganged up on them — but we felt, “Hey, this is a better way to go.”

Q Is that one of those instances in which you had to take a harder line?

A I think that’s about as hard a line as we’ve taken.

Q How has the business changed since you first got in?

A You’re starting to see a dichotomy between the big firms tending to take some market share and consolidations going on at those kind of levels, but you’re also seeing boutiques being able to open up.

Part of that is the result of Charles Schwab & Co. and Morningstar. Morningstar has made it clear you need to spend more time looking at managers. It’s not just short-term performance that counts, it’s other things.

With Schwab, you have the ability to buy and sell no-load mutual funds without having to fill out all the application forms, which is a big, big difference. And the planner market has exploded as a result of that. And they can, in effect, become educators to the people, so they can make more educated decisions than before.

Q Is this a good change?

A Overall, I would think you’re going to have more stability, a little longer-term orientation, less movement on the basis of psychology and more on the basis of logic, so yeah, I think so. We’ll see as it plays out.

Clearly, in a bad period some of the planners who are small will get hurt and there’ll be a shakeout, and maybe more consolidation in that business gradually, but I think it’s a level that’s here to stay. I don’t think it’s going to disapp ear.

Ten years ago, or certainly the early ’90s when we started, there were people who thought this was a fad. I don’t think it’s a fad. I think people want to save money.

It’s just another service out there. Like lawn care is a service. And people are becoming more used to using services that are specialists in certain areas for different things, whether it’s doctors, lawyers, whatever, investment advisers.

vitae

Donald Yacktman,

56, president, Yacktman Asset Management, Chicago.

Yacktman Fund

(assets $796 million) returns: year-to-date, 3.68%; 1-year, 8.59%; 3-year, 20.37%; 5-year, 18%.

Mid-cap blend average: year-to-date, 9.97%; 1-year, 21.32%; 3-year, 21.32%;

5-year, 17.32%.

Yacktman Focused Fund

(assets $69.7 million) returns: year-to-date, 8.2%; 1-year, 14.33%.

Mid-cap value average: year-to-date, 6.97%; 1-year, 18.54%.

Standard & Poor’s 500 stock index: year-to-date, 17.7%; 1-year, 32.15%; 3-year, 30.22%;

5-year, 23.06%.

Source: Morningstar Inc.; data through June 30 with annualized returns for periods over one year.